Time for a crash course on estate planning, and how our President may be missing the boat.
If you’re looking into establishing or revamping your estate plan, you’ve likely heard the old adage “from shirtsleeves to shirtless in three generations.” This saying essentially means is that if one doesn’t have an airtight dynasty plan for transferring wealth through future generations of their family, most of the money could be gone in as little as three generations. If you haven’t given much thought to the tax efficiency of your estate plan strategy, your grandchildren may be the ones who suffer the consequences.
An Example: Donald Trump
One example of a faulty estate planning tactic that’s recently surfaced in the media is the apparently poor estate tax planning of President Donald Trump.
According to this article, if Donald Trump were to die today, he would leave his family with upwards of $1.3 billion in state and federal estate taxes. Forbes suggests that Trump doesn’t seem to have passed much of his estate at all on to his wife Melania or two youngest children. They estimate that his three oldest children have received approximately $35 million total in salaries, commissions, and bonuses for their work as executives at the Trump Organization. This has left Donald Trump with around $3.1 billion of assets. Mostly owned through hundreds of holding companies, to be subjected to hefty estate taxes. This cost could be even greater when you consider the cost to liquidate assets so that he can pay the IRS in 9 months. It is unlikely Trump keeps $1.3 Billion in cash. Not to mention the IRS wants to be paid in cash, not golf resorts or the Trump Tower.
While Trump has openly criticized the estate tax, calling it a “horrible tax” and a “lousy weapon that has destroyed many families,” his children are still not exempt from it. By comparison, Sam Walton gave 80% of his stake in Walmart to his children. Walton argued that “the best way to reduce paying estate taxes is to give your assets away before they appreciate.” Some have said that President Trump’s reasoning behind his avoidance of passing assets to the next generation is to maintain control over his wealth. Potentially unbeknownst to Trump, there are many ways to maintain control over one’s current equities while establishing a means of passing wealth onto your children in a tax-efficient manner.
Donald Trump’s legacy plan would likely be much better off if it utilized the significant estate tax mitigation techniques that we employ at M3 Wealth Advisors for our Family Office clients. Strategic tax considerations on a legacy plan is something that most individuals can benefit from. Not just billionaires or the president.
M3 Wealth Advisors approach
The challenge for wealthy families like the Trumps is that the IRS puts an estate tax box around everything we own, and we need to provide an inventory on the final tax return that will be filed on our behalf after we die, the dreaded form 706. The approach to estate planning financial tragedy is simple.
With proper planning estate taxes can be minimized or eliminated for most of us; and if estate taxes need to be paid, then they can be deeply discounted by using the tools the government provides us and a bit of creativity. Everything we own is trapped in our estate tax box. We pay tax to government when we earn the income, pay sales taxes when we buy things. Added to that property tax on many of the things we buy like real estate, cars and boats, taxes on our investments as they grow. And then the IRS puts up a series of tolls between you and your generations.
Fortunately, if we are married when we die the IRS allows us to pass 100% of what we own to our spouse. Trump can leave his $3.6 Billion to Melania if she survives him. But he may not want to give up control and he may miss out on his unlimited marital deduction. That said, those assets plus what our spouse owns will be subject to an estate tax after both you and your spouse die and be divided between the government and your kids/other heirs.
Some of the goals of estate planning are:
- To keep everything, you buy or accumulate outside your estate tax box.
- Transfer assets inside the box outside the estate tax box.
To accomplish these goals, the federal gift exemption allows you to drill holes in the estate tax box and use creative strategies to leverage the value of these transfers to generate (5 to 1), (10 to 1) or even (20 to 1) value of the precious cargo of gift allowance.
Gifting your Assets
To start with, you can give assets away to your loved ones. Us taxpayers can gift $15,000 per year to anyone. This is a “use it or lose it” annual gift allowance. By husband and wife combining their gift capacity, they can gift $30,000 per year. Over time and with growth, this can accumulate to a significant amount that will escape taxes. Beyond the annual gift, we all have a lifetime gift exemption currently equaling $11,400,000. If you exceed these limits during your lifetime, you need to pay a gift tax. We can give this away while we are alive, or this is the amount that will transfer tax-free to our heirs at death.
The value of gifting this during lifetime is that your heirs benefit from the gift plus future growth. Many attorneys will suggest using a trust called IDGT (Intentionally Defective Grantor Trust, essentially a trust on steroids), you can give assets away using your exclusion and lifetime exemption. This way, you retain the responsibility to pay the income taxes due each year on the growth of the trust. This becomes an additional gift tax-free transfer each year, which makes the holes in the estate tax box bigger.
This enables you to give away the asset, the growth on the asset, and the taxes due on the growth. It’s clear that you can pay less in taxes and give away more to your heirs by planning and gifting in advance. In our experience, many clients are reluctant to do so. They don’t want to give up control of their assets, and they worry about what will happen if they end up needing the money in the future. This is where creativity comes in. For many clients, freezing discounts and leveraging the value of the gifting capacity the IRS allows helps them to retain control while mitigating future estate tax exposure.
This involves a two-part solution.
1) FLLC (Family Limited Liability Company)
Step one is to set up a Family LLC and transfer assets you believe are going to accumulate into the LLC. The LLC can be split between manager interest and economic interest. the grantor can retain the managing interest in the LLC. this gives the Grantor 100% control over the LLC and all the assets. The economic interest of the LLC is gifted to a trust for the benefit of the grantor’s heirs.
This gift can count against the grantor’s annual exclusion and lifetime exemption. Another advantage of this approach is that the lack of liquidity and voting rights in the gifted economic interest permits the taxpayer to take a discount for lack of marketability and control. For example, it may be possible to transfer almost $8M of assets for using a $5.4M exemption.
Another option that can provide even greater leverage is to sell the LLC interest to the trust and take advantage of the low-interest rates called AFR of 2.24% for 30 years. In this example, $20M of LLC value is sold to a defective trust. At a 6% investment rate, the value in 30 years grows to almost $80M, and the $20M note is repaid, resulting in the transfer of $64M of value outside the estate tax box.
Installment Sale of $20M LLC value to an IDGT
Terms: Interest only 2.24 AFR, 30 years Balloon Note
Assumption 6% ROR, defective trust grantor pays income tax, 100% of earnings accumulate.
The FLLC allows for total control over the asset, and the defective trust provides that added transfer benefit of paying taxes on behalf of the trust growth. However, what if the parents need to access their money? Part of the solution is the sale vs. an outright gift. In this example, the $20M note can be called at any time so that this can be a payment back to the grantor from year 1 to its culmination in year 30.
2) SLAT (Spousal Lifetime Access Trust).
You as the grantor can make your spouse a beneficiary of the trust and allow him/her to have access to any income that the trust earns, and even the principal if he or she needs it. You can even set up a line of credit between the trust and your spouse in the event that there is a temporary cash need. The key is that you can provide backdoor access to this asset and if you do not need the funds, then it will all pass to your heirs as beneficiaries outside the estate tax box. The trust provisions can protect your spouse, children and even grandchildren and allow you to keep assets in the family in the event of a divorce or other adverse circumstances.
Suppose that you are able to freeze discount and transfer a significant portion of your estate outside your estate tax box, but not all of it and you would still have to pay estate taxes.
The solution could be to use life insurance as an asset class to be able to discount the cost of the estate tax bill or provide the liquidity. You can set up an insurance trust called an ILIT, and rather than have you or your spouse own the policy and have the life insurance come back into the estate tax box, it gets paid to the trust. Your spouse can be the beneficiary of the trust and receive income and principal while alive, but afterwards 100% of the assets pass for the benefit of your heirs and can provide the funds need for payment of taxes.
If there are no taxes, then the insurance is a tax-free death benefit to the trust that is available for your heirs. Do you think the Prince’s family would have an interest in a $250M life insurance trust about now?
Since insurance is not free, and the premiums for a trust-owned policy are considered gifts that count against your annual exclusion and lifetime gift exemption, we can use a concept called split money. If you own a business, your corporation can lend the premiums to the trust and significantly reduce the gift impact of the premiums.
At M3 Wealth Advisors our estate planning tool kit is based upon our experience of working with very sophisticated and complex estates for the past 25 years. FLLCs, IDGT’s, SLAT’s, GRATS, self-canceling notes, cash settled options, charitable trusts and split money with an ILIT – these are some of the tools that may hold value in a particular investor’s situation. More important than the tools are your goals and objectives for your life and your children. This leads to the design of the plan and the use of the tools and planning that is best designed to leverage the tax code for your particular situation.
Of course, each investor’s situation is unique, and financial planning is a deeply personal experience. The scenarios and techniques discussed above are merely for illustration only and not indicative of any specific plan. Past results are not an indicator of future investment success. We are not tax or legal advisors. Any tax or legal information provided herein should be reviewed with a competent, qualified legal or tax advisor. Investment advisor services are offered through Integrated Wealth Concepts, a federally registered investment advisor.
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